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Penn State - RUS 100 - Costs of Financial Distress 16 - Study Guide

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Penn State - RUS 100 - Costs of Financial Distress 16 - Study Guide

School: Pennsylvania State University
Department: Russian
Course: Corporate Finance
Term: Spring 2014
Tags:
Description: Costs of Financial Distress 16
Uploaded: 07/08/2017
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background image Costs of Financial Distress 16.1 Good Time Company is a regional chain department store. It will remain in business for one more year. The
probability of a boom year is 60% and a recession is 40%. It is projected that Good Time will generate a 
total cash flow of $250 million in a boom year and $100 million in a recession.  The firm’s required debt 
payment at the end of the year is $150 million. The market value of Good Time’s outstanding debt is 
$108.93 million. Assume a one-period model, risk neutrality, and an annual discount rate of 12% for both 
the firm’s debt and equity.  Good Time pays no taxes.
a. What is the value of the firm’s equity?
b. What is the promised return on Good Time’s debt?
c.
What is the value of the firm? d. How much would Good Time’s debt be worth if there were no bankruptcy costs?
e.
What payoff, after bankruptcy costs, do bondholders expect to receive in the event of a recession? f. What cost do bondholders expect Good Time to incur should bankruptcy arise at the end of the year? 16.2 Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered.  
Both companies will remain in business for one more year.  The companies’ economists agree that the 
probability of a recession next year is 20% and the probability of a continuation of the current expansion is 
80%.  If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of  $2 
million.  If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $0.8 
million.  Steinberg’s debt obligation requires the firm to pay $750,000 at the end of the year.  Dietrich’s 
debt obligation requires the firm to pay $1 million at the end of the year.  Neither firm pays taxes.  Assume 
a one-period model, risk neutrality, and an annual discount rate of 15%.
a. Assuming there are no costs of bankruptcy, what is the market value of each firm’s debt and equity?
b. What is the value of each firm?
c.
Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s since the firm 
has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?
16.3 What are the direct and indirect costs of bankruptcy? Briefly explain each. 16.4 “A firm’s stockholders will never want the firm to invest in projects with negative net present values.” Do you agree or disagree with this statement. Explain your answer. 16.5 Due to large losses incurred in the past several years, a firm has $2 billion in tax-loss carry-forwards.  This 
means that the next $2 billion of the firm’s income will be free from corporate income taxes.  Security 
analysts estimate that it will take many years for the firm to generate $2 billion in earnings. The firm has a 
moderate amount of debt in its capital structure.  The firm’s CEO is deciding whether to issue debt or 
equity in order to raise the funds needed to finance an upcoming project. Which method of financing would
you recommend? Explain.
16.6 Fountain Corporation economists estimate that a good business environment and a bad business 
environment are equally likely for the coming year.  The managers of Fountain must choose between two 
mutually exclusive projects.  Assume that the project Fountain chooses will be the firm’s only activity and 
that the firm will close one year from today.  Fountain is obligated to make a $500 payment to bondholders 
at the end of the year. Assume the firm’s stockholders are risk-neutral. Consider the following information 
pertaining to the two projects:
Project Value  Value Value Economy Probability Payoff of Firm of Equity of Debt Bad 0.5 $500 $500 = $0 $500 Good 0.5 $700 $700 = $200 $500 Low-Risk Project
background image a. What is the expected value of the firm if the low-risk project is undertaken? What if the high-risk  project is undertaken? Which of the two strategies maximizes the expected value of the firm? b. What is the expected value of the firm’s equity if the low-risk project is undertaken? What if the high- risk project is undertaken?  c. Which project do Fountain’s stockholders prefer? Explain. d. Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather  than total firm value and opt for the high-risk project. To minimize this agency cost, the firm’s 
bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher 
payment if Fountainhead chooses to take on the high-risk project.  By how much would bondholders 
need to raise the debt payment so that stockholders would be indifferent between the two projects?.
16.7 What measures can stockholders undertake to minimize the costs of debt? 16.8 How do the existence of financial distress costs and agency costs affect Modigliani and Miller’s theory in a 
world where corporations pay taxes?
16.9 What are the sources of the agency costs of equity? Personal Taxes 16.10 Fortune Enterprises is an all-equity firm that is considering issuing $13.5 million of perpetual 10% debt.  
The firm will use the proceeds of the bond sale to repurchase equity.  Fortune distributes all earnings 
available to stockholders immediately as dividends.  The firm will generate $3 million of earnings before 
interest and taxes (EBIT) every year into perpetuity.  Fortune is subject to a corporate tax rate of 40%. 
Financial information for the firm under each of its two possible financial structures is shown below:
a. Suppose the personal tax rate on interest income (T B ) and equity distributions (T S ) is 30%. i. Which plan do equity holders prefer? ii. Which plan does the IRS prefer?
iii. Suppose equity holders demand a 20% return after personal taxes on the firm’s unlevered equity.  
What is the value of the firm under each plan? b. Suppose T B  = 0.55 and T S  = 0.20.  i. What is the annual after-tax cash flow to equity holders under each plan?  ii. What is the annual after-tax cash flow to debt holders under each plan? 16.11 When bankruptcy costs are considered, the general expression for the value of a levered firm in a world in 
which the tax rate on equity distributions (T
S ) equals zero is: Project Value  Value Value Economy Probability Payoff of Firm of Equity of Debt Bad 0.5 $100 $100 = $0 $100 Good 0.5 $800 $800 = $300 $500 High-Risk Project Unlevered Levered EBIT 3,000,000 3,000,000 Interest - $                1,350,000 EBT 3,000,000 1,650,000 Taxes 1,200,000 660,000 $     Net Income 1,800,000 990,000 $    

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School: Pennsylvania State University
Department: Russian
Course: Corporate Finance
Term: Spring 2014
Tags:
Description: Costs of Financial Distress 16
Uploaded: 07/08/2017
5 Pages 190 Views 152 Unlocks
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  • 24/7 Homework help
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